By Mitchell Anthony
September 23, 2020
The Markets Recent Volatility
The equity markets have been going through a bit of a correction over the last two weeks. This is the first correction since the February-March 2020 correction that occurred due to the coronavirus outbreak and the shutdown of the global economy. After this correction the markets ran wild to the upside after the central bank and the US Congress essentially stated that they would monetize their way out of this economic problem. Valuations soared in industries and names that were highly leveraged to the stay at home environment that ensued and continues today. Cyclical names have also rebounded but the performance has been far different as these cyclical names are not leveraging the current environment but in fact impacted by the current environment. The rally in both has now paused as investors assess the likelihood of a second stimulus package from the US Congress. The stimulus package has stalled because of a few areas within the Democratic demands that the Republicans have not been able to stomach. Most notably bailouts for states and local governments that acted irresponsibly for many many years. The Republicans just want less stimulus for consumers and small businesses than the Democrats want. The Republicans are hung up on principle for the time being but likely will fold when they realize that maintaining control of the presidency and the Senate are more important than blocking stimulus now that will just happen later if they lose control. Investors obviously worry and as a result stocks have corrected 10% or more from their highs recently. This correction will likely end soon if it hasn’t already as the economy continues to stay on a path of recovery and interest rates remain at zero and the fact is there is nowhere else to put your money besides risk oriented investment areas like stocks or real estate.
Is there Irrational Exuberance in our Economy?
Irrational exuberant talk has emerged again over the last few weeks as people try to assess valuations in the market. This phrase can be applied to stock prices as well as the economy and it is certainly more important to evaluate regarding the economy. When there is irrational exuberance in the economy the outlook for growth is poor as overcapacity leads to layoffs and bad economic times. Fortunately we do not have much in the way of exuberance in any sector of our economy let alone irrational exuberance.
Are the Equity Markets Irrationally Exuberant?
One could certainly argue that investors supporting and purchasing real estate, stocks, and gold are exuberant. This is reasonable given the fact that interest rates are near zero and the central bank is flooding the market with liquidity that has to go somewhere. Stocks are clearly the best valued asset of these three classes. The Cap Ratios on real estate are at all-time highs, and gold is close to all-time highs with no inflation on the horizon. Stocks on the other hand are not selling at all-time high PE ratios or PEG ratios or even close. The best way to value stocks is to look at their PE ratio relative to the underlying growth rate of the company. Historically when this peg ratio is two or more the stock is likely to correct.
Valuations in the Secular Growth Names
Secular growth names like Facebook, Amazon, Apple, Netflix, and Google have great secular tailwinds driving these companies growth as well as cyclical tailwinds currently. All of these names have peg ratios under 1.5. There is no doubt the stocks have had tremendous moves over the last year but at the same time the underlying earnings are accelerating from already high levels.
Valuations in Cyclical Stocks
Most of the industrial sector, financial sector, and cyclical consumer areas have been highly impacted by the Covid 19 environment and as a result the outlook for an earnings recovery in these areas is poor let alone these areas getting back on a path of growth. The valuation on these areas looks dramatically different as you place different assumptions about growth on these companies. Optimism about a quick recovery to normalcy has ebbed and flowed over the last few months and as a result the valuations on these names have been high and low.
Liquidity is still high
There is tremendous liquidity in the marketplace and lots of fuel to push stocks higher as sentiment improves about stimulus and growth. This liquidity has interest rates locked up at zero and will eventually find its way back into stocks.
We remain optimistic.